Oil Market Volatility and the Quants: What to Know

After a number of years of relative price stability, the oil market is again dealing with wilder fluctuations on a more regular basis.

Volatility has returned to the oil markets with a vengeance. After a number of years of relative price stability, the oil market is again dealing with wilder fluctuations on a more regular basis. This turn of events is partly due to the explosion of U.S. shale oil production, and global uncertainty in the supply and demand outlook. But there’s another factor in the heightened volatility: Increased usage of economic and technical trading indicators have been pushing prices around with high velocity. Furthermore, changes in trading practices over the past decade have also contributed to volatility, not least of all algorithmic and high-frequency trading (HFT).

Players using complex algorithms to trade—who are often referred to as the “quants”—at essentially speed-of-light attempts to gain advantage over competition that uses human intelligence and reaction times. Quants are essential for liquidity, but they have altered crude futures trading, with more emphasis on technicals and links with other financial markets. They use short-term strategies and typically do not hold positions overnight. In other words, they are in the market for quick profits and use technical analysis instead of trading based upon physical fundamentals.

Against the backdrop of higher volatility this year, trading volumes are up, suggesting that speculative traders like the quants have become more active.

Against the backdrop of higher volatility this year, trading volumes are up, breaking the 1 million level for daily lots on both ICE Brent and NYMEX WTI, suggesting that speculative traders like the quants have become more active. Implied volatility has soared to above 70 percent at times this year. That is well below the record 120 percent in 2008-9, but it has shattered the illusion of price stability seen for about five years, until the collapse in the middle of last year. In fact, for a two-year span from August 2012 to August 2014, implied volatility averaged just 18 percent.

It is important to note that financial players who rely on automated systems and technicals do not necessarily cause the volatility themselves. Rampant price swings have always been entrenched in the oil markets—oil is an exhaustible commodity and geopolitical risk causes instability as some 90 percent of reserves are owned by national oil companies. Moreover, human emotions (most notably fear and greed) have distorted markets over time, while today’s world of fast-moving but inadequate or incomplete news from wire service headlines or Twitter feeds makes traders jumpy. While volatility provides many opportunities for traders, it is a villain for producers and consumers alike, as both need to make long-term decisions despite uncertainty about where prices will be.

But algorithmic traders, which make up around one-third to one-half of crude futures trading based on different estimates, do indeed exaggerate price moves and in turn steepen volatility, as technical indicators prompt the automatic buying or selling of a large amount of contracts at one time. “So-called black boxes [algorithmic trades] are capable of reacting to market data, transmitting thousands of order messages per second, cancelling and replacing orders based on changing market conditions, and capturing price discrepancies with little or no human intervention,” said Carol Clark and Rajeev Ranjan of the Federal Reserve Bank of Chicago in a 2012 study.

Attracted to volatility

Algorithmic traders are attracted to oil futures in particular because of the volatility—the greater the price swings, the greater the opportunities for profit based on their mechanisms.

Algorithmic traders are attracted to oil futures in particular because of the volatility—the greater the price swings, the greater the opportunities for profit based on their mechanisms. They also find crude a good play because of the deep liquidity on the commercial side (those who have a direct interest in physical crude), allowing them to enter and exit the market quickly. Simply put, every transaction must involve both a buyer and a seller, so with a variety of commercial participants in crude futures, which include producers, hedgers, refiners, end-users, and banks, traders can normally find someone on the opposite side of the deal.

Although the quants are active in crude, they move back and forth between markets. With oil futures “financialized,” or tightly linked with other financial markets, news headlines about the global economy bring about swift reactions in the trading world. Against this backdrop, a herd mentality tends to take shape and contribute to wild swings, in all markets. Algorithmic trading accelerates price moves, with trends becoming a self-fulfilling prophecy given that many traders use similar technical analysis—the buying or selling of contracts once a certain price level is breached. Their increased presence can also be seen in crude’s interconnectedness with other markets: From 2009-2013, the crude futures market and the S&P had a 90 percent positive correlation, while crude and the dollar have had an inverse correlation of 60-70 percent.

Although some firms date back to the 1980s or 1990s, high-speed technical traders started becoming big players in crude during the middle of last decade when ICE went fully electronic, software technology made major strides, and trading houses preferred recruits with mathematics and physics degrees instead of those with a finance background or deep knowledge of physical fundamentals. NYMEX has shifted to all electronic, too, making it easy for new entrants using automated systems. As a result, volumes in the derivatives now are now some 20 to 30 times greater than the physical market. The crude futures and derivatives market has a wide variety of participants, many of whom have no interest in physical oil. Non-commercials such as banks, hedge funds, commodity trading advisors, and other money managers are particularly active, while fund managers have added commodities such as oil to investor portfolios as alternatives to equities and bonds for diversification. Against this backdrop, high-frequency and other algorithmic traders are some of the many financial investors in the market.

With growing competition among trading houses and speed (even milliseconds matter) a major component to success, firms have paid exchanges such as the CME and the NYSE thousands of dollars per month to place their servers physically near the exchanges so they can gain an advantage.

Newer trading practices under fire

With their growing importance in recent years, high-frequency and other financial traders have come under heavy scrutiny. A report by the UN Conference on Trade and Development (UNCTAD) in 2012 said that HFT distorts the crude market and called on regulators to limit their role. “The financialization of commodity markets has an impact on the price determination process,” said researchers at UNCTAD. “Commodity markets are more and more prone to events in global financial markets and likely to deviate from their fundamentals.”

Bart Chilton, former commissioner at the Commodity Futures Trading Commission (CFTC), was well-known throughout the financial and energy world for referring to HFTs as “cheetahs.” Greg Scopino, who works in the Division of Swap Dealer and Intermediary Oversight for the CFTC, said in a study earlier this year that some HFT practices may in fact be illegal, while author Michael Lewis’ best-selling book Flash Boys, which exposes firms’ dubious practices, is still the subject of debate. Some HFT firms have been fined for manipulation and breaking rules on a number of exchanges, but regulators have not taken meaningful steps to restructure markets to limit their activity.

The quants are thriving

Although the quants have come under scrutiny, many are well established and thriving.

Although the quants have come under scrutiny, many are well established and thriving. Major algorithmic trading houses have been active for decades. Some of the big quants in oil markets today, such as Jump Trading, Tower Research Capital, and DRW, migrated from the NYMEX trading floor, when open outcry—trading done between humans on exchange floors—dominated, to electronic trading firms. Many were “local” traders, or speculators who traded with their own money for their own account on the floor of the NYMEX, before setting up automated trading houses.

Bloomberg News, in a detailed report late last year, stated “the quants are winning,” showing how returns reflected the quants’ success across a variety of different markets, an indication of how distinct an advantage algorithmic traders have. A number, in fact, positioned themselves well to profit handsomely off the oil price drop. Top quant hedge funds saw massive returns last year, with one posting increases of 47 percent. A number of high-speed firms came out big winners during the stock market turmoil this past August.

“Scientists, mathematicians and engineers are beating star managers by capturing price discrepancies across markets, making money from a plunge in oil prices and on government bonds that human traders dismissed,” said Bloomberg in last year’s piece.

Given that watchdogs have found automated trading difficult to regulate and some quants have seen massive profits from their trading strategies, they are here to stay in oil futures and all markets—adding to price volatility along the way.

A number of firms have not been so lucky, however, losing out by being on the wrong side of trades and suffering steep declines in profits, with some even having to close up shop. And during the years of limited volatility on the exchanges, profits came under pressure. Given that watchdogs have found automated trading difficult to regulate and some quants have seen massive profits from their trading strategies, they are here to stay in oil futures and all markets—adding to price volatility along the way.

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The Fuse is an energy news and analysis site supported by Securing America’s Future Energy. The views expressed here are those of individual contributors and do not necessarily represent the views of the organization.

Issues in Focus

Safety Standards for Crude-By-Rail Shipments

A series of accidents in North America in recent years have raised concerns regarding rail shipments of crude oil. Fatal accidents in Lynchburg, Virginia, Lac-Megantic, Quebec, Fayette County, West Virginia, and (most recently) Culbertson, Montana have prompted public outcry and regulatory scrutiny.

2014 saw an all-time record of 144 oil train incidents in the U.S.—up from just one in 2009—causing a total of more than $7 million in damage.

The spate of crude-by-rail accidents has emerged from the confluence of three factors. First is the massive increase in oil movements by rail, which has increased more than three-fold since 2010. Second is the inadequate safety features of DOT-111 cars, particularly those constructed prior to 2011, which account for roughly 70 percent of tank cars on U.S. railroads. Third is the high volatility of oil produced from the Bakken and other shale formations, which makes this crude more prone towards combustion.

Of these three, rail car safety standards is the factor over which regulators can exert the most control. After months of regulatory review, on May 1, 2015, the White House and the Department of Transportation unveiled the new safety standards. The announcement also coincided with new tank car standards in Canada—a critical move, since many crude by rail shipments cross the U.S.-Canadian border. In the words DOT, the new rule:

Since the rule was announced, Republicans in Congress sought to roll back the provision calling for an advanced breaking system, following concerns from the rail industry that such an upgrade would be unnecessary and could cost billions of dollars. The advanced braking systems are required to be in place by 2021.

Democrats in Congress have argued that the new rules are insufficient to mitigate the danger. Senator Maria Cantwell (D-WA) and Senator Tammy Baldwin (D-WI) both issued statements arguing that the rules were insufficient and the timelines for safety improvements were too long.

The current industry standard car, the CPC-1232, came into usage in October 2011. These cars have half inch thick shells (marginally thicker than the DOT-111 7/16 inch shells) and advanced valves that are more resilient in the event of an accident. However, these newer cars were involved in the derailments and explosions in Virginia and West Virginia within the past year, raising questions about the validity of replacing only the DOT-111s manufactured before 2011.

Before the rule was finalized, early reports indicated that the rule submitted to the White House by the Department of Transportation has proposed a two-stage phase-out of the current fleet of railcars, focusing first on the pre-2011 cars, then the current standard CPC-1232 cars. In the final rule, DOT mandated a more aggressive timeline for retrofitting the CPC-1232 cars, imposing a deadline of April 1, 2020 for non-jacketed cars.

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DataSpotlight

The recent oil production boom in the United States, while astounding, has created a misleading narrative that the United States is no longer dependent on oil imports. Reports of surging domestic production, calls for relaxation of the crude oil export ban, labels of “Saudi America,” and the recent collapse in oil prices have created a perception that the United States has more oil than it knows what to do with.

This view is misguided. While some forecasts project that the United States could become a self-sufficient oil producer within the next decade, this remains a distant prospect. According to the April 2015 Short Term Energy Outlook, total U.S. crude oil production averaged an estimated 9.3 million barrels per day in March, while total oil demand in the country is over 19 million barrels per day.

This graphic helps illustrate the regional variations in crude oil supply and demand. North America, Europe, and Asia all run significant production deficits, with the Middle East, Africa, Latin America, and Former Soviet Union are global engines of crude oil supply.